The Case for Buying Call Options

Buying call options allows bullish traders to capitalize on a stock's gains without putting a lot of dollars at risk

Managing Editor
May 5, 2017 at 12:56 PM
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    The U.S. presidential election sparked a massive stock market rally, with the major market indexes hitting record highs in 2017. However, there is still a lot of skepticism toward the future, and how the market will react to a series of global events. In the face of this skepticism, customization and fine-tuning your investment strategy can help maximize your returns while minimizing risk. Below, we're going to discuss the advantages of buying call options over purchasing a stock outright.

    The advantages of call options

    Options contracts offer customization. When a trader is bullish on a stock, most of the time he or she will purchase the shares outright. However, by purchasing call options -- which represent 100 shares of the stock, and give the buyer the right (not the obligation) to purchase those shares at the strike price -- the trader can capitalize on the equity's upside momentum by putting fewer dollars at risk. This makes buying call options an appealing concept.

    There are two factors that make buying options unique; the strike price, and the expiration date. Buying a call option is essentially making the prediction that the underlying stock will rise in value by a certain amount (above the strike), within a certain time frame (prior to expiration). Further, long call options come with limited risk compared to buying a stock outright, so buying calls is for traders who are bullish, yet want to maintain as much as leverage as possible with their position.

    An example of the leverage they provide

    The leverage you receive when buying calls is twofold. First, it costs less to purchase calls than if you were to buy the stock outright. Second, and perhaps more important, buying calls stem your potential losses, should the stock not hit the strike price. 

    You feel bullish about Stock XYZ, which is currently trading at $100 per share. You see that a 100-strike call with three months until expiration is asked for $4.50. If you bought that contract for $450 ($4.50 x 100 shares per contract), you will begin to profit if XYZ tops the $104.50 mark (strike plus premium paid) by the expiration date. In fact, profits are theoretically unlimited to the upside, as your call will move deeper into the money the higher XYZ moves above $100.

    If you had instead bought 100 shares of XYZ for $100 apiece, you would have had to pay the full share price of $10,000. You are controlling the same number of shares for a fraction of the price.

    Let's say XYZ rallies to $110 by expiration. The 100-strike call would hold $10 in intrinsic value -- minus the $4.50 paid, the buyer could pocket $5.50, or $550, more than doubling their investment. A move to $110 would generate a $1,000 profit for the shareholder, which is more money on an absolute basis, but only a 10% return on his or her initial investment.

    Even a loss of 5 points in XYZ, to $95, would cost the shareholder $500 ($5 x 100 shares) -- more than the call buyer's loss on an XYZ move to zero. The call buyer's loss is capped at the premium paid for the calls -- for this example, $450 -- even if the shares fall to zero. However if you had purchased outright shares of XYZ, losses would reach as high as $10,000 on a trip to zero. 

    As always with options contracts, there is a key word in the fine print; the right. Buying a call option gives you the right, but not the obligation, to buy the stock. Traders have the option to sell to close their in-the-money calls before expiration, or exercise the call and buy the shares at discount to what they'd cost on Wall Street.

    Tips when looking to buy calls

    The anticipated stock target should be reflected in the strike price, and the length of time you expect it to take the stock to reach that target should be reflected in your expiration date. We recommend you take an Expectational Analysis approach to stock analysis, and consider the usual factors that influence an options price. Implied volatility is one. 

     

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